All E&P companies face challenges and production is a constant battle. One reason we especially like certain Canadian E&P dividend paying equities is the generally respected nature of their dividends along with the flexibility of their capital program. Because Canada has a very nascent high yield market, companies often need the equity market to raise capital. As such, many of these companies pay out what we see as significant yields to attract investors and often treat their dividends in the same manner as an interest payment. In many cases, they recognize their dividend payments are extremely valuable and will do almost anything to protect them.
In terms of the flexibility of the Canadian E&P’s capital program, if a company runs into trouble with production, this will mean less cash flow (production * cash netback = cash flow), but they will easily be able to scale back their drilling program to keep the dividend intact. Clearly they cannot keep missing production guidance and scaling back capex, but the simple payout ratio gives us a feel for how far they can miss production estimates. Two other very important things we look for to mitigate this problem are low decline rates and large reserve life indexes (RLIs). A low decline rate means you can produce oil for a longer period of time without having to drill more holes. A reserve life index is the hypothetical number of years it would take to deplete a company’s reserves at current production rates. Combining both of these qualities means less drilling activity needs to take place to keep production constant.
Yield-based investors must focus on the sustainability of that yield, be it a company’s interest payments or dividends. While there are some seemingly attractive opportunities in exploration and production companies, especially Canadian-based producers, investors need to understand the company’s financial dynamics to assess that residual cash flow availability to service these payments and the ultimate dividend sustainability.
This article was written by Tyler Gramatovich, Analyst for Peritus Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD).